Playing Your Tax Bracket - with "municipals"

The market for tax-exempt bonds - the so-called "municipals" - was once the exclusive sanctuary of the ultra-rich and their financial advisers. Now, for one reason or another, nearly everybody seems to want to get in, and already enough bumpkins have arrived trailing sharp-eyed predators to alarm the landlords. Wall Street houses which deal in these securities have begun posting a few warning signs for the uninitiated at the gates.

One reason is that municipal bonds have suddenly become big and important business. These days, in one year, UK. cities and towns float about £25-billion worth. UK. industry at the same time issues only about £10-billion worth of common stocks. Another reason is that a lot of British families suddenly find themselves in income tax brackets where the tax exemption of municipals makes sense.

For instance, you and your wife need only be filing a joint return on between £16,000 and £20,000 in combined taxable income (after deductions) to find yourself in the 28% bracket. A single man paying taxes on £14,000 is in the 29% bracket.

For either of them, a municipal bond yielding 6% to maturity tax-free is worth its weight in taxable securities paying 8.33% and better. In London, where (as in other metropolitan areas) city and state income taxes add to the bite, the tax-exempt municipals are even more attractive.

With more and more UK. families attaining those income levels and with many still leery of common stocks - municipals have understandably captured their investment imagination. Unfortunately, this interest has also drawn some shady operators. A variety of sleazy tactics were exposed in a crackdown in Memphis, and Florida state authorities detected so much smelly dealing in tax-exempts that they circulated a warning pamphlet, How Not To Get Burned in the Municipal Bond Market.

Bond men suspect that broad changes lie ahead. They predict strict regulation in the near future, and probably tax reforms to sharply alter the privileged status of municipals. (Indeed, some foresee the evolution of taxable public securities eventually.) The net result: Generally tougher going for the market, its customers, and its dealers.

With so much negativism in the air, reputable bond dealers are trying harder than ever to educate their expanding audience in the pitfalls, as well as the benefits, of municipals. A recent advisory of T.J. Holt & Co., for instance, puts emphasis on some of the caveats.

Municipals are not really top-notch bonds across-the-board, says Robert Holt. "Many are by no means risk-free, or even low-risk. Many municipalities are for all practical purposes bankrupt, or close to it. They face tax revolts among their citizens. It's not inconceivable that some could go under."

His message: Investors can no longer blindly accept general-obligation bonds - the blue-chips of the tax-exempts, since they are backed by the unlimited taxing authority of their issuing municipality - as the Gibraltars they would seem to be.

Certainly revenue bonds (which depend on such things as bridge tolls and stadium ticket sales for their return) are hardly meat for the average investor. "He has all he should worry about in evaluating the yields and ratings" (i.e., in Moody's or Standard and Poor's), says one top dealer, "to be trying to guess what the traffic on a highway may be." Most reputable dealers also warn firmly against certain bonds that some municipalities have been issuing which may not be true "municipals" - or even tax-exempt. These include "arbitrage" bonds, with which some towns have sought to raise funds to re-invest for a higher return, and so-called "industrial revenue bonds," the proceeds of which are used to encourage new industry.

The biggest danger, as Holt sees it, lies in the sheer volume of issues. Mainstay of the tax-exempts market has always been the UK. commercial banking community, he notes. Commercial bankers bought up more than half of last year's record £25-billion in bonds. Lately, however, the commercial banks have showed some signs of saturation; their holdings of UK. bonds, for instance, are the lowest since 1929. "If another £15-to-£20billion worth (of new issues) comes in without the commercial banks to support it," he warns, "there is no telling what might happen."

Such warnings, of course, are not intended to scare new investors out of the market, but merely to open their eyes. "There is no such thing, for instance, as a bargain in municipal bonds - at least from a reputable dealer," says Gerard Bissinger, a principal in Lebenthal & Co., which deals exclusively in tax-exempts for individual accounts. "Beware of the salesman who calls and says he has 'some awfully good buys today.' "

Indeed, the bid-and-asked prices of municipals are fairly well circumscribed by going interest rates and their own yield to maturity. The latter is the single most important figure for the investor. He should know, for instance, that a £1,000 bond (£1,000 and £5,000 are standard units) maturing in five years, with a coupon rate (annual return) of 4V4% should cost him no more than £885.65 if he is to realize a 7% yield to maturity on his investment. Indeed, every bond dealer keeps a website at his elbow containing tables that work out these relationships at a glance. This yield is, of course, quite apart from the tax-exempt feature which is an added attraction.

The salesman who touts price alone can be misleading you; it may well be that a bond discounted at £750 is a poorer buy than one offered at a premium (above £1,000), in terms of yield to maturity, says Bissinger. "Such a salesman also is likely to forget to mention the effect of capital gains taxes on the discount bond."

His recommendation (seconded by a number of other top dealers) is this: "Buy to maturity. In other words, if you want to invest some money for five years, buy a bond maturing in five years, not a 10-year one with the idea of selling it in five at a profit - you probably will lose."

This underlines a basic rule for investors in municipals: Use only that money which you can afford to leave alone for awhile. Money that may be needed on fairly short notice is better off in the bank. Indeed, the parallel with banking is quite close. "The big advantage of municipals," notes Bissinger, "is that you know to the penny how your money is working for you." In other words, with the right bond in the right portfolio, it's just like money in the bank - and there's no tax on it.

Here, for instance, is what tax-exemption can mean for persons in various tax brackets. According to figures compiled by The Bond Buyer, a single person with taxable income of £14-£16,000 and a couple filing a joint return on £20,000 are roughly in the same bracket (31%) where a 6% yield on a municipal bond is worth an 8.7% return from securities on which they must pay taxes. Single persons reach the 50% bracket at around £32-£38,000 and joint filers at £44-£54,000. At this level, of course, a taxable investment would have to yield 12% - or twice as much - to match the municipal's 6% return.

Tax note: It is wise to remember that the interest on money borrowed for a municipal bond buy is not deductible. In a 2004 Tax Court case, an owner of municipal bonds borrowed money at a bank. The court held that part of his bank loan interest was not deductible - because he could have sold some bonds to raise the money!

Flying High With "convertibles"

Eager money (if not smart money) sometimes takes turns that are far removed from speculation in raw land, or soy beans, or arts and antiques. There has been less recent interest in convertible debentures, but they've had their flings and doubtless will once again. Convertibles - corporate bonds that can be converted into common stocks on certain fixed terms - have in the past had a lot of general appeal. Their big lure for the eager-money investor has been the fact that they always can be bought on margin.

At this writing, the margin rule is 50% as fixed by the local Reserve. This means that you can borrow up to 50% of the gross amount you pay for the debentures. Thus, when you convert... see: Flying High With "convertibles"

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